Before 2008, the majority of Americans were more likely to know derivatives from calculus than from the finance industry. Since then, one of the main types of derivatives contracts, credit default swaps, have earned an unsavory reputation that The Wall Street Journal suggests hardly does them justice.
Tied to the generally negative view many Americans hold of the finance industry, CDS are generally seen as a means of making money, stealing if they are particularly uncharitable. But looking at the structure of these contracts gives a different sense.
A derivative is a contract between two institutions that establishes payments on a particular schedule based on agreed upon criteria. The name “derivative” notes that the contract has no inherent value, but references some other asset, such as sovereign bonds, or figure, such as the interest rate in a country.
For CDS, the asset being referenced is some form of debt from an individual or institution. The now-infamous collapse of American International Group came when a large number of individuals defaulted on mortgages that the company had insured. At present, the largest concern in the derivatives market is the potential for Greece to default on government issued bonds, but these contracts can fall anywhere within the range between those two groups.
Usually the institution buying a CDS pays on a quarterly basis, though some contracts are more frequent. The payout for these contracts comes when the company, country or individual defaults on whatever debt it owes. Sometimes, as in a person declaring bankruptcy, this can be clear-cut, but The New York Times notes that for sovereign debt and corporate bonds, there is usually an extended process to establish the exact size and nature of the damages and thus how much must be paid on CDS contracts.
Many people look at this and see only the potential to profit from someone’s failure, and certainly the potential for speculation exists. However, the initial purpose of these contracts was always as a means of reducing the risk associated with certain investments, spreading it between institutions. Investors could better justify paying for Greek bonds, providing money for the government, if they could also secure some insurance against the country’s failure to pay the bond back.
Recently, The Journal notes that India has established rules for CDS in that country to allow greater investment in some smaller domestic firms that otherwise might seem too large a risk. Even the World Bank has encouraged the use of derivatives by developing nations to help stabilize the price of food, according to Reuters, suggesting the poor reputation is largely undeserved.